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MENTORING - General - Financial instruments - Coggle Diagram
MENTORING - General - Financial instruments
A financial instrument is a security or a contract exchanged by a buyer and a seller depending on their perception of the market.
In both cases, money is exchanged for a security or a contract. That means for buying a security or a contract, the buyer pays money. The seller takes that money and gives that security or a contract.
These financial instruments are the modes through which money travels from savers to investors or investors to investors or from
impatient to patient.
Asset managers or real money use these instruments to take exposure to the market. We will also follow them in buying or selling these instruments.
What are the financial instruments available in India for trading or investing?
Before buying or selling financial instruments (securities or contracts), an asset manager looks for one important thing -
liquidity
In this context, liquidity of financial instruments means the ease with which a trader or investor can get in and get out of the instrument.
What are the financial instruments available for trading in India?
What are the examples of financial instruments? Stocks, bonds, interest rates, forwards, futures, options, forward rate agreements, interest rate swaps, swaps, credit-default swaps, foreign exchange and any over-the-counter contracts.
In India, only
cash equities (stocks), futures and options
are liquid. Rest are not liquid and their markets are not deep enough to trade or invest.
Hence, asset managers trade or invest only in these three instruments in India. We will discuss only them.
Cash equity is a ownership on a company. If an asset manager buys cash equity, it is having an ownership in a company. It is like owning a house. For this an investor should lay the full money (cost) on the table. That means he should not have used leverage to buy that.
Cash equity bought on margin or leverage (that means debt) is not ownership. It is a liability. The true owner will be the one who gave the leverage or margin.
Futures are contracts between a buyer and a seller to deliver the cash equity on the expiry day.
A future contract gives the buyer the right to own a stock on or before the
expiry day
. The owning or converting the right to ownership is called
exercising/executing
the contract. The last date for such a contract is called the expiry date, after which the contract ceases to exist.
To buy a future, the buyer has to pay a part of the ownership value. That is called the futures margin.
An option gives the buyer the right but not the obligation to own shares in cash equity. In an option contract, the buyer only pays a premium, but not the entire margin or cash required for buying. However, if he exercises the contract, he has to pay the full money like in futures.
Futures and options are called derivative contracts. Because they are derived from cash equity.
An option buyer pays the premium for an exposure to cash equity through the option contract. This premium keeps decreasing in value as we move towards expiry. This is famously called theta decay.
Asset managers use all these securities and contracts to make money through investing or trading. Hence these three are very very important in the Indian market context.